On the Renminbi: The Choice between Adjustment Under a Fixed Exchange Rate and Adjustment Under a Flexible Rate
27 Pages Posted: 6 Dec 2004
There are 2 versions of this paper
On the Renminbi: The Choice between Adjustment Under a Fixed Exchange Rate and Adjustment Under a Flexible Rate
On the Renminbi: The Choice between Adjustment Under a Fixed Exchange Rate and Adjustment Under a Flexible Rate
Date Written: August 2004
Abstract
Summary of key points:
A fixed exchange rate and a flexible exchange rate each have its own advantages.
A country should have the right to choose the regime best suited to its circumstances.
Nevertheless, the de facto dollar peg may now have outlived its usefulness for China.
China's economy has recently crossed over into the overheating side of internal balance, and appreciation would help easy inflationary pressure.
A second reason to allow appreciation and thereby reduce the balance of payments surplus is that, although foreign exchange reserves are a useful shield against currency crises, by now China's current level is fully adequate, and US treasury securities do not pay a high return.
Another reason is that it becomes increasingly difficult to sterilize the inflow over time, exacerbating inflation.
Although external balance could be achieved by expenditure reduction, e.g., by raising interest rates, the existence of two policy goals (external balance and internal balance) in general requires the use of two independent policy instruments (e.g., the real exchange rate and the interest rate).
While a very small open economy might be able to rely on adjustment in the price level, and thus to keep the exchange rate fixed, a large economy like China is better off achieving adjustment in the real exchange rate via flexibility in the nominal exchange rate.
There are other arguments for flexibility as well. The experience of other emerging markets suggests that it is better to exit from a peg when times are good and the currency is strong, than to wait until times are bad and the currency is under attack.
Since May 2004, investors' demand for emerging market debt has suddenly begun to ease, in anticipation of an imminent period of rising US interest rates. It might be worth waiting to see if China's balance of payments surplus persists after the tightening of US monetary policy has begun, before further financial liberalization.
From a longer-run perspective, prices of goods and services in China are low - not just low relative to the United States (.23), but also low by the standards of a Balassa-Samuelson relationship estimated across countries (which predicts .36).
In this specific sense, the yuan was undervalued by approximately 35% in 2000, and is by at least as much today.
Typically across countries, such gaps are corrected halfway, on average, over the subsequent decade.
The correction could take the form of either inflation or nominal appreciation, but the latter is preferable.
These arguments for increased exchange rate flexibility need not imply a free float. China is a good example where, contrary to the popular corners hypothesis, an intermediate exchange rate regime like a target zone is more appropriate.
Keywords: Economics - International Economics, Economics - Macroeconomics
Suggested Citation: Suggested Citation
Do you have a job opening that you would like to promote on SSRN?
Recommended Papers
-
The Chinese Approach to Capital Inflows: Patterns and Possible Explanations
By Eswar S. Prasad and Shang-jin Wei
-
The Chinese Approach to Capital Inflows: Patterns and Possible Explanations
By Eswar S. Prasad and Shang-jin Wei
-
By Eswar S. Prasad, Thomas Rumbaugh, ...
-
The Impact of Tax Morale and Institutional Quality on the Shadow Economy
By Benno Torgler and Friedrich Schneider
-
The Overvaluation of Renminbi Undervaluation
By Yin-wong Cheung, Menzie David Chinn, ...
-
The Overvaluation of Renminbi Undervaluation
By Yin-wong Cheung, Menzie David Chinn, ...
-
Assessing China's Exchange Rate Regime
By Jeffrey A. Frankel and Shang-jin Wei
-
Assessing China's Exchange Rate Regime
By Jeffrey A. Frankel and Shang-jin Wei